227 research outputs found

    Estimating Equity Risk Premiums

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    Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium, looking forward. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets

    Research and Development Expenses: Implications for Profitability Measurement and Valuation

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    Most valuation models begin with a measure of accounting earnings to arrive at cash flow estimates. When using accounting earnings, we implicitly assume that the income is obtained by netting out only those expenses that are operating expenses, i.e., expenses designed to generate revenues in the current period. Expenses that are intended to provide benefits over multiple periods are assumed to be considered as capital expenditures, and these expenses are depreciated or amortized over multiple periods. In addition, when computing profitability measures such as return on equity and capital, we stick with this assumption that operating income measures income generated by assets in place. In this paper, we examine the accounting treatment of research and development expenses, and the effects of the treatment on operating income, capital and profitability. We argue that research and development expenses should be treated as tax-deductible capital expenditures, for purposes of valuation, and this can have significant effects on operating income, capital and expected growth measures for firms with substantial research expenses

    Estimating Risk Parameters

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    Over the last three decades, the capital asset pricing model has occupied a central and often controversial place in most corporate finance analysts’ tool chests. The model requires three inputs to compute expected returns – a riskfree rate, a beta for an asset and an expected risk premium for the market portfolio (over and above the riskfree rate). Betas are estimated, by most practitioners, by regressing returns on an asset against a stock index, with the slope of the regression being the beta of the asset. In this paper, we attempt to show the flaws in regression betas, especially for companies in emerging markets. We argue for an alternate approach that allows us to estimate a beta that reflect the current business mix and financial leverage of a firm

    Financing Innovations and Capital Structure Choices

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    The last two decades have seen a stream of innovation in financial markets, especially in the corporate bond arena. Some of these innovations were designed to give firms more flexibility in designing cash flows on borrowings, allowing them to match up cash flows on financing more closely to cash flows on assets, thus increasing their debt capacity. These changes have been for the most part good news for corporate treasurers, but the relentless torrent of innovation has also resulted in some firms issuing these new and more complex securities for the wrong reasons. Some have done so to keep up with other firms in their peer group, and other to take advantage of loopholes in the way ratings agencies and regulatory agencies define debt and equity. In this context, it is worth noting that as corporate bonds have become more complex, investment bankers once more become indispensable to the process, proving both pricing and selling support. It is important that firms recognize when complexity serves their interests, and when it can end up hurting them

    Dealing with Operating Leases in Valuation

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    Most firm valuation models start with the after-tax operating income as a measure of the operating income on a firm and reduce it by the reinvestment rate to arrive at the free cash flow to the firm. Implicitly, we assume that the operating expenses do not include any financing expenses (such as interest expense on debt). While this assumption, for the most part, is true, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease expenses are treated as part of the operating expenses, but we will argue that they really represent financing expenses. Consequently, the operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have significant effects not just on valuation model inputs, but also on some multiples such as Value/EBITDA ratios that are widely used in valuation

    Estimating Risk Parameters

    Get PDF
    Over the last three decades, the capital asset pricing model has occupied a central and often controversial place in most corporate finance analysts’ tool chests. The model requires three inputs to compute expected returns – a riskfree rate, a beta for an asset and an expected risk premium for the market portfolio (over and above the riskfree rate). Betas are estimated, by most practitioners, by regressing returns on an asset against a stock index, with the slope of the regression being the beta of the asset. In this paper, we attempt to show the flaws in regression betas, especially for companies in emerging markets. We argue for an alternate approach that allows us to estimate a beta that reflect the current business mix and financial leverage of a firm

    The Promise and Peril of Real Options

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    In recent years, practitioners and academics have made the argument that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. They have noted that these options need to be not only considered explicitly and valued, but also that the value of these options can be substantial. In fact, many investments and acquisitions that would not be justifiable otherwise will be value enhancing, if the options embedded in them are considered. In this paper, we examine the merits of this argument. While it is certainly true that there are options embedded in many actions, we consider the conditions that have to be met for these options to have value. We also develop a series of applied examples, where we attempt to value these options and consider the effect on investment, financing and valuation decisions

    Employee Stock Options (ESOPs) and Restricted Stock: Valuation Effects and Consequences

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    In the last decade, firms have increasingly turned to offering employees options and restricted stock (often with restrictions on trading) as part of compensation packages. Some of this trend can be attributed to the entry of young, cash poor technology firms into the market, many of which have to use equity because they have no choice. However, many larger market cap firms that can afford to pay cash compensation have used stock based compensation as a way of aligning managerial interests with stockholder interests. In this paper, we begin by looking at motives, good and bad, for using equity based compensation, and trends over the last few years. We then turn to the accounting rules, old and new, that govern how equity compensation is recorded and reported. Finally, we consider how best to incorporate employee options and restricted stock – both past and prospective – into discounted cash flow and relative valuation models

    The Dark Side of Valuation: Firms with no Earnings, no History and no Comparables

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    In traditional valuation models, we begin by forecasting earnings and cash flows and discount these cash flows back at an appropriate discount rate to arrive at the value of a firm or asset. This task is simpler when valuing firms with positive earnings, a long history of performance and a large number of comparable firms. In this paper, we look at valuation when one or more of these conditions does not hold. We begin by looking ways of dealing with firms with negative earnings, and note that the process will vary depending upon the reasons for the losses. In the second part of the paper, we look at how to value young firms, often a year or two from start-up, with negative earnings, small or negligible revenues and few comparables. We will argue that while estimation of cash flows and discount rates is more difficult for these firms, the fundamentals of valuation continue to apply. Finally, we look at how best to do relative valuation for young firms with negative earnings and few comparables

    Estimating Equity Risk Premiums

    Get PDF
    Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium, looking forward. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets
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